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Journal of Accounting and Economics 11 (1989) 143-181.

North-Holland

AN ANALYSIS OF INTERTEMPORAL AND CROSS-SECTIONAL


DETERMINANTS OF EARNINGS RESPONSE COEFFICIENTS*

Daniel W. COLLINS
University of low, Iowa Ci+, IA 52242, USA
Duke lJniversi{v, Durhum, NC 37706, USA

S.P. KOTHARI
University of Rochester, Rochester, NY 1462 7, USA

Received November 1987. final version received February 1989

Stock price change associated with a given unexpected earnings change (the earnings response
coefficient) exhibits cross-sectional and temporal variation. We predict and document evidence
that the earnings response coefficient is a function of riskless interest rates and the riskiness,
growth and/or persistence of earnings. The earnings response coefficient also varies cross-section-
ally with the holding period return interval. Collectively, our results explain the previously
reported differential earnings response coefficient with respect to size. Moreover, by including the
factors noted above, the empirical specification of the earnings/returns relation is significantly
improved.

1. Introduction

Considerable research has focused on the relation between security returns


and unexpected earnings to assess the information content of the latter.
Typically, inferences regarding the information content of earnings are based
on the significance of the slope coefficient (b) and explanatory power (R*) of
the following linear model estimated cross-sectionally and/or over time:

CAR,, = a + bUXi, + ejt,

where CAR if is some measure of risk-adjusted return for security i cumulated


over period I, UX;, is a measure of unexpected earnings (appropriately scaled),

*This paper has benefited from workshop discussions at the University of Chicago, Iowa,
Michigan, Minnesota, MIT, Ohio State, Rochester, the Stanford Summer Camp, and the Interna-
tional-Symposium on Forecasting at Boston. We acknowledge R. Ball, V. Bernard, L. Brown, S.
Choi. P. Easton. J. Fellineham. G. Foster. T. Harris, P. Healv R. Kormendi, R. Leftwich, S. Linn.
T. Linsmeier. B. Lipe. RrLundholm, J. Ohlson, B. Ricks, M. Weisbach, P. Wilson, R. Young, J.
Zimmerman, M. Zmijewski, and especially R. Watts and S. Penman (the referee) for their
comments on earlier versions of the paper. We are particularly grateful to Johannes Ledolter and
Mike Rozeff for extended discussions.

01654101/89/$3.5001989, Elsevier Science Publishers B.V. (North-Holland)


144 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

and ei, is a random disturbance term assumed to be distributed N(0, u,). The
slope coefficient, b, is called the earnings response coefficient (ERC).l
Generally, the returns/earnings relation is investigated using either an
events study or an association study method. The event studies infer
whether the earnings announcement, per se, causes investors to revise their cash
flow expectations as revealed by security price changes measured over a short
time period (typically, 2-3 days) around the earnings announcement. Exam-
ples include Foster (1977), Hagerman, Zmijewski, and Shah (1984), and
Wilson (1986, 1987). In essence, the focus is on whether earnings announce-
ments convey information about future cash flows.
In an association study, returns over relatively long periods (fiscal quarters
or years) are regressed on unexpected earnings or other performance measures
such as cash flows [Raybum (1986)] or replacement cost earnings [Beaver,
Griffin, and Landsman (1982)] estimated over a forecast horizon that corre-
sponds roughly with the fiscal period of interest. Association studies recognize
that market agents learn about earnings and valuation-relevant events from
many nonaccounting information sources throughout the period. Thus, these
studies investigate whether accounting earnings measurements are consistent
with the underlying events and information set reflected in stock prices.
Typically, causality is not inferred. Rather, the focus is on whether the
earnings determination process captures in a meaningful and timely fashion the
valuation relevant events.
Regardless of the perspective used, the bulk of the extant empirical litera-
ture assumes the returns/earnings relation is homogeneous across firms. The
slope b in eq. (1) is treated as a cross-sectional and temporal constant. Recent
studies relax this assumption to improve eq. (1)s specification and explanatory
power [see, e.g., Beaver, Lambert, and Morse (1980) Ohlson (1983), Miller and
Rock (1985) Kormendi and Lipe (1987), and Easton and Zmijewski (1989)].
By combining alternative valuation models with different earnings process
assumptions these studies provide important insights into factors that explain
variation in ERCs.
This study provides further insights into factors contributing to differential
ERCs in an annual association study context. In contrast to the previous work,
we examine temporal as well as cross-sectional determinants of ERCs. The
temporal variation in ERCs is hypothesized to be negatively related to the
risk-free interest rate. We expect cross-sectional variation in ERCs to be
positively related to earnings persistence and negatively related to firms
systematic risk. In addition, we hypothesize that ERCs are positively related to
growth opportunities that are not likely to be fully captured by persistence

In using the term response we do not imply causality. The term is used in a generic sense to
measure the degree of comovement between security returns and shocks to an earnings series
without necessarily implying that the latter cause the former. The distinction is made clearer
below.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 145

estimated using time series models. Our empirical results are consistent with
all these predictions.
We also demonstrate empirically that the earnings/returns relation varies
with firm size, where size is a proxy for information environment differences.*
Differences in information environment affect the extent to which price
changes anticipate earnings changes [Collins, Kothari, and Rayburn (1987)
and Freeman (1987)]. Once differences in the information environment are
controlled by varying the return holding period, there is little difference in the
extent to which price changes covary with earnings changes across firm size.
This explains the differential magnitude of ERCs as a function of firm size
documented in Burgstahler (1981), Freeman (1987), and Collins et al. (1987).
Our analysis also suggests that association studies that use a holding period
corresponding to a firms fiscal period (or between earnings announcement
dates) understate the earnings/returns association. Holding periods that begin
at an earlier point in time and span a longer time horizon enhance the
earnings/returns association relative to the conventional twelve-month hold-
ing periods, particularly for larger firms.
In section 2 we identify the determinants of ERCs using a simple dividend
capitalization model where accounting earnings are assumed to be related to
future dividends. In section 3 we discuss how noise in accounting earnings
measurement and variation in the information environment affect the estima-
tion of ERCs. We also propose ways to deal with these problems empirically.
Section 4 identifies the sample used in our empirical analysis. Section 5
demonstrates differences in the strength of earnings/returns relation for large
versus small firms as one varies the return holding period. Section 6 is broken
into two parts: first, variation in the earnings/returns relation over time and
its association with long-term risk-free interest rates are documented; second,
cross-sectional variation in the earnings/returns relation and its association
with risk, earnings persistence and/or growth are documented. Section 7
summarizes our findings and discusses some of the implications of our results
for past and future research.

2. Equity valuation and determinants of earnings response coefficients


This section outlines an equity valuation model in which price is the
discounted present value of future expected dividends. By specifying a positive
relation between current earnings and future expected dividends, we relate the
current periods earnings shock to unexpected stock returns via the ERC. We

Information environment is defined broadly to include all sources of information relevant to


assessing firm value. It includes government reports on macroeconomic conditions, industry
reports and trade association publications, firm-specific news in the financial press and reports
issued by analysts and brokerage houses in addition to accounting reports, and vertical and
intra-industry information transfers via sales and industry reports.
146 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

then discuss the cross-sectional and temporal determinants of the ERCs which
provide the basis for our empirical investigation. Finally, we compare the
determinants of the ERCs identified in this study with those in the related
literature.

2.1. Equity valuation and the earnings response coefJicient

The price of security i at time t may be written as

P,,= ft E,(%+k)
k=l
Tfil
{l/i1 + E(fL+,)l>~
where

E,( Di,+k) = expectation at time t of dividends to be received at the end of


period t + k, and
E( R i1+7) = expected rate of return on the security from the end of t + T - 1
to the end of t + 7.

In writing eq. (2), the future expected rates of returns are assumed known and
the only uncertainty about future prices is due to reassessments through time
of expected future dividends. These assumptions, together with the other
assumptions underlying the Sharpe-Lintner Capital Asset Pricing Model
(CAPM), are sufficient for the multiperiod CAPM to hold [Fama (1977)].
To derive the ERC, we assume accounting earnings are related to future
dividends and, hence, unexpected earnings cause investors to revise their
expectations of future dividends leading to security price changes. Future
expected dividends are assumed to be related to current earnings according to

E,(&+k) = hir+kXr, A,r+k 0, k=1,2 ,..., oo, (3)

where X,, is firm is reported accounting earnings for period t. While the
assumption in eq. (3) is ad hoc, it is useful in generating empirical predictions
tested later in the paper. Moreover, the dividends/earnings relation in eq. (3)
underlies, at least implicitly, the empirical analysis in numerous previous
studies, including Ball and Brown (1968), Freeman (1987), Kormendi and Lipe
(1987), and Easton and Zmijewski (1989). The precise values of the hittks will
depend on the particular time series process that earnings follow as a function
of the firms investment and dividend policies. The next section demonstrates
how alternative earnings process assumptions affect the Xitiks and the ERCs.
Substituting eq. (3) into (2):
D. W. Collins and S. P. Koihari, Variation in earnings response coeJicients 141

The unexpected return associated with unexpected earnings is derived using


eq. (4) as

R;z- Et-i(R,,) = [P;,- E,-i(Pi,) + Di,- E~-~(D,,)I/PL~-~


or

uR,,= f~
{L[1
[ it+k
x*, + Z
k=l
(5)
>1U&/ft-~>
+E(&+,)I 7=1

where UX,, = X,, - E,-,( X,,) is the unexpected earnings in period t. Eq. (5)
relates unexpected earnings to unexpected returns and the coefficient on
unexpected earnings scaled by price is the ERC (the bracketed term).

2.2. Determinants of the earnings response coe@cient

Eq. (5) reveals that, ceteris paribus, the ERC is inversely related to the
expected rate of return on a security. Because we assume complete knowledge
of future expected rates of returns consistent with the multiperiod CAPM, we
can substitute the Sharpe-Lintner CAPM relation in each period:

E(h) = R/t + [E(R,,,)- R/t]6,. (6)


Using the CAPM eq. (6) and further assuming that pi, is either constant
through time or highly positively autocorrelated through time, we conclude
that the ERC is a decreasing function of a securitys systematic risk. In
valuation terms, the higher the systematic risk the smaller the present value of
a given increase in expected future dividends caused by unexpected earnings.
The ERC is affected positively by the hit+k s which relate current earnings
to future dividends. If the earnings time series has a high persistence (i.e.,
current periods earnings shocks tend to persist in the future and affect future
earnings expectations), then dividend expectations will be revised more than if
earnings shocks have low persistence. Thus, the higher the earnings persistence
the higher the hrr+k~.
The effect of persistence on ERC can be shown more formally in the context
of a specific earnings process. Earnings persistence is typically measured by
estimating an ARIMA time series earnings process [e.g., Kormendi and Lipe
(1987)]. If earnings follow an IMA(l, 1) process, earnings expectations for all
future periods will be revised by (1 - fl)a,, where a, = X, - E,_,( X,) and 0 is
the moving average process parameter. Thus, revisions in earnings expecta-
tions are an increasing function of (1 - e), the persistence of an IMA(l, 1)
process. Because dividends are assumed a positive fraction of earnings, greater
persistence will lead to larger revisions in dividend expectations and the ERC
will be larger. Implications of persistence under alternative earnings process
148 D. W. Collins and S. P. Kothari, Variation in earnings response coeflcients

Table 1
Persistence factors under different ARIMA earnings processes

Persistence factor Sum of the present value of A E, ( X, + k )s


k periods in future over all k time periods, discounted at

or
Earnings process AE,(X,+,) =+ku, interest rate of rb

ARIMA(O.l, 0) 1
[random walk]

ARIMA(O,O, 1) -@.a, k=l


[Miller and Rock 0 k>l

(19W1
1-O
r a,
L-1
ARIMA(O.1, 1) (1-B)u, forall k
[Beaver, Lambert,
and Morse (1980)]

ARIMA(1,O.O)
++1
[Easton and
Zmijewski (1989)]

ARIMA(2,l.O) (1+ r)/r


-1 a,
[ Kormendi and 4, = (1 + +,)a, k= 1 1 - &/(l + r) -$5/Q + r>* I
Lipe (1987)]

u, = X, - E,_ i( X,) is the shock in period ts earnings, Earnings follow an ARIMA time series

prYess.
Following Kormendi and Lipe (1987) and Flavin (1981), the present value of the revisions in
earnings expectations caused by (I, over an infinite horizon for an ARIMA( p, d, q) process is a
function of the AR( c$) and MA( 8) paramenters as follows:

One plus the bracketed term in the last column gives the theoretical earnings response coefficient
for that particular earnings specification.

assumptions used in previous studies are presented in table 1. Assuming


constant discount rates and an isomorphic relation between future earnings
expectations and future dividend expectations, one plus the right column in
table 1 presents the theoretical ERC for each of the alternative earnings
processes. The theoretical ERC is the price change induced by a one-dollar
shock to current earnings and is equal to one plus the present value of the
revisions in expected future earnings caused by this shock. Therefore, the ERC
D. W. Collins and S.P. Kothari, Variation in earnings response coejficients 149

is expressed in terms of the autoregressive [AR(+)] and moving average


[MA( 0)] parameters of the alternative ARIMA earnings specifications accord-
ing to the formula adapted from Kormendi and Lipe (1987) and Flavin (1981).
Many valuation models express firm value as the sum of the present value of
dividend stream from investments yielding a normal rate of return and
growth in future dividends stemming from the existence of investment oppor-
tunities that are expected to yield an above normal rate of return [see, e.g.,
Fama and Miller (1972, ch. 2)]. The normal rate of return is the rate of return
commensurate with the riskiness of investments in a competitive industry.
Growth because of investing in projects that yield above normal rates of
return in generally referred to as economic growth. Ceteris paribus, the future
earnings and dividend streams will be larger in the presence of growth
opportunities than absent such opportunities. Hence, if the current earning
surprise is informative of the growth opportunities, the hil+k~ are expected to
be a positive function of growth opportunities.
In the context of classic valuation models [e.g., Miller and Modigliani
(1961)] current earnings may not necessarily reveal growth opportunities
because in these models only future investments are assumed to earn above
normal rates of returns. Realistically, however, current earnings are a result of
investments in both growth and no-growth projects. Accordingly, growth
opportunities include investments in new as well as existing projects where the
profit rate (m) differs from the normal rate of return (r). Current earnings are
likely to signal useful information about the changing spread between 7r and r
for the current investments as well as for future investments. Moreover,
current earnings and current dividends may jointly signal managements
private information about growth opportunities on future investments. For
example, Easton (1985) finds a negative relation between current dividends
and future dividends after controlling for the current earnings effect. This is
consistent with lower current dividend payout signalling higher future divi-
dends because of earnings invested in projects where 7~> r.
A key question that remains is whether time series persistence estimates
fully and accurately capture economic growth opportunities. We believe this is
problematic for at least two reasons. First, time series analysis cannot distin-
guish between correlation in successive earnings numbers brought about by
mere expansion (i.e., earnings reinvestment through time or increases in
external financing) versus economic growth. The latter has shareholder wealth
implications while the former does not. Second, and perhaps more important,
ARIMA models typically assume parameter stability. Therefore, any trend
term that picks up earnings expansion and/or growth is constrained to be a
constant. This is a limiting assumption, particularly when estimates are based
on annual data for a 20-30-year time frame [see Kormendi and Lipe (1987)].
Given a competitive environment and dynamic macroeconomic conditions,
economic growth opportunities are likely to be short-lived. Accordingly, fixed
150 D. W. Collins und S.P. Kothnri, Variation in earnings response coefficients

parameter ARIMA estimates derived from lengthy time series represent some
sort of a weighted average of changing growth opportunities over time.
Because we expect the persistence estimates from time series models to be
deficient in accurately reflecting current growth opportunities, we include a
proxy for the latter as an additional determinant of ERCs.
In addition to the three cross-sectional determinants of the ERC, we
hypothesize interest rates as a temporal determinant of the ERC. To derive a
temporal relation between interest rates and the ERC, we assume that the
expected rates of returns in the future periods vary over time. That is,
E(Rit+7) can vary over t. We further assume that the current risk-free interest
rate is highly positively autocorrelated with the future risk-free interest rates.
Because the risk-free interest rates are a component of E(R,,+,), the higher the
current risk-free interest rate the higher the expected rate of return on the
security in the future periods. Therefore, we predict a negative relation
between interest rates and the ERC through time.3
In hypothesizing the negative temporal association between interest rates
and the ERC, we deviate from the assumption underlying the discounted cash
flow model and the multiperiod CAPM that all the future E( R,,,,) are known
at time t and, thus, cannot vary with t. However, relaxing this assumption
generates an interesting empirical prediction and is consistent with the evi-
dence that both nominal and real interest rates change through time [see, e.g.,
Ibbotson and Sinquefield (1985)]. If the ERC is derived using continuous time
valuation models like Merton (1973) or by allowing uncertainty in future
commodity prices and the future investment opportunity sets [Long (1974)],
the effect of interest rate variation through time on the ERC will enter into the
model more directly. These extensions are beyond the scope of this paper, but
are fruitful avenues for future research.
To summarize, we identify four factors contributing to cross-sectional and
temporal differences in the ERC. The ERC is positively related to earnings
persistence and economic growth opportunities. The ERC is negatively related
to the securities future expected discount rates. The discount rate is made up
of (i) the risk-free interest rate, R,, and the market risk premium, and (ii) the
firms CAPM beta risk. Because R, and the market risk premium are the same
for all firms, they obviously are not a source of cross-sectional variation in
ERCs. The ERCs are negatively related to the interest rate levels through time
and the CAPM beta risk in the cross-section.

3We use a partial equilibrium analysis to examine the interest rate effect on the ERG. Interest
rate changes affect, among other things, the saving/investment decisions of individuals and
corporations which, in turn, affect the firms future cash flows. Incorporating these effects on cash
flows and their present values to derive a relation between interest rates and the ERCs requires a
complete equilibrium analysis that is beyond the scope of this paper. We essentially ignore the
saving/investment and associated cash flow implications of interest rate changes in making our
predictions.
D. W. Collins und S. P. Kothari, Vuriation in eurnings response coefficients 151

Previous studies identify persistence and systematic risk as the determinants


of ERCs. The Garman and Ohlson (1980) and Ohlson (1983) earnings capital-
ization models suggest that ERCs are positively related to the extent to which
current periods unexpected earnings lead to revisions in future periods
dividends and earnings (i.e., earnings persistence) and inversely related to the
systematic risk of earnings. Miller and Rock (1985) derive the effect of
earnings persistence and systematic risk using a two-period model.
Kormendi and Lipe (1987) and Easton and Zmijewski (1989) derive ERC
determinants using a discounted cash flow valuation model. The primary
difference between their analysis and ours is that they derive the ERC by
assuming a specific time series earnings process, namely, an autoregressive
earnings process. Both these studies provide evidence that persistence has a
positive effect on ERCs and Easton and Zmijewski (1989) report a modest
negative relation between beta risk and ERCs. However, neither study explic-
itly considers the effect of growth on the ERCs. Effectively, the impact of
growth opportunities on ERCs is assumed to be fully captured by their
earnings persistence measures. Our previous discussion and subsequent empir-
ical analysis reveal that persistence estimates are unlikely to capture economic
growth fully.

3. Estimation problems and methodological considerations

3.1. Error in measuring unexpected earnings and returns

The covariance between unexpected returns (UR ir) and unexpected earnings
(UR,,) can be summarized as follows:

c+> (-> (+I c-1


cov(W,Jx,,) =f( P ersistence, risk, growth, interest rates ).
cross-&tional temporal
variation variation

Empirically, at least two other factors affect the estimated COV(UR,~,UX,~)


and, hence, the estimated ERC: (a) noise in reported accounting earnings as
an indicator of future expected dividends and (b) the firms information
environment.
The above two factors lead to error in measuring UX,,. Empirical proxies for
UX,, contain error because: (i) Accounting earnings measure firms future
dividend paying ability with error. The market uses other variables in addition
to accounting earnings in forecasting future expected dividends and in this
sense unexpected accounting earnings is a noisy predictor of revisions in
future expected dividends. (ii) The markets earnings expectation at a given
152 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

point in time differs from a simple time series earnings expectation proxy. The
presence of competing (and more timely) sources of information in addition to
reported earnings renders the time series earnings expectation a noisy measure
of UXi, [see, e.g., Collins et al. (1987) and Freeman (1987)].
Measurement error in a UXi, proxy attenuates the ERC and makes it
difficult to detect the influences of the ERCs determinants. The bias in an
estimated ERC can be substantial. Indeed, evidence in Beaver et al. (1980)
suggests that ERCs estimated at the individual security level using a time
series earnings expectation proxy for UX,, understate the true or theoretical
ERCs by as much as 70-80%, on average.
If we could obtain a better measure of the markets earnings expectation at
time r - 1, the measurement error problem in a proxy for UXi, would be
reduced. However, empirically this is difficult. While analysts forecasts are
better than time series proxies [Brown et al. (1987a, b)], they are not available
in a machine-readable form over the time period examined in this study and
they are generally available only for the larger, more widely held firms. An
alternative approach to reduce the measurement error problem is to set t - 1
(i.e., the beginning of the holding period) at a point such that the time series
proxy (in our case, a random walk specification) approximates the markets
earnings expectation. We adopt the latter approach by varying the return
window.
Varying the return window ensures that a particular UX,, proxy matches up
closely with the true (but unobservable) market earnings expectation and
provides a specification check on previous work relating earnings changes to
security returns. This allows us to u e the same earnings expectation model
across all firms (which is typically done in empirical work) and find the point
in calendar time when that particular proxy best approximates the markets
earnings expectation for a particular firm. This ensures that the estimated
response coefficient fully captures the markets valuation of unexpected earn-
ings. Varying the return window also allows us to assess how this affects the
earnings/returns association as measured by adjusted R* across firm size.4
In addition to error in UX,, proxy, cross-sectional differences in the infor-
mation environment contribute to nonrandom variation in the earnings/
returns relation. If firm size is a proxy for information environment differ-
ences, then different size firms will exhibit different ERCs on measuring UXjrs
over a fixed holding period for all firms [see, e.g., Collins et al. (1987)]. In this
sense returns measured over fixed holding periods contain error. Holding the
earnings expectation model and the return cumulation period constant across
all firms can result in a spurious association between firm size and ERCs in an

41f returns are the dependent variable and we vary the length of the holding period from one
model to another, then the adjusted Rs are no longer comparable since the total sum of squares
will differ from one model to another.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients 153

annual association study. This spurious correlation occurs because of differ-


ences in the lead-lag structure in the earnings/returns relation caused by the
information environment differences for large versus small firms. Moreover, if
the lead-lag relation between returns and earnings changes is ignored and
time series proxies for UX,, are used, then association studies will severely
understate ERCs.

3.2. Reverse regression and the return response coejicient


We use multiple regressions to test whether various factors identified earlier
are related to the ERCs. To address the measurement error problem, we
employ reverse regression [see Maddala (1977) Learner (1978), Klepper and
Learner (1984), and Beaver, Lambert, and Ryan (1987)]. Specifically, we
regress earnings changes on returns and a series of terms representing interac-
tions between returns and risk, growth and/or persistence, and interest rates.
We adopt this approach over various grouping procedures in direct regression
for several reasons.5
First, using a UX;, proxy as the dependent variable reduces the attenuation
bias that exists when ERCs are estimated at the individual security level using
eq. (1). Second, having returns on the RHS allows us to conveniently test for
differences across firm size in the lead-lag relation by incorporating both
contemporaneous and earlier periods returns as explanatory variables. Fi-
nally, with returns on the RHS, we can vary the length of the return holding
period for different firms (i.e., combine varying portions of contemporaneous
and leading returns into one metric). As noted earlier, by varying the length of
the return window we control for cross-sectional differences in information
environment because the return period is expanded until the markets expecta-
tion of current periods earnings is approximated by the prior years earnings
(i.e., earnings change is now unexpected).6
One consequence of using reverse regression is that we estimate the return
response coefficient (RRC) rather than the ERC. The reciprocal of RRC is an
estimate of the ERC in the simple regression context. This interpretation is

See Beaver et al. (1980) for a discussion of alternative grouping procedures in direct regression
to mitigate measurement error in I/X,, proxies. Beaver, Lambert, and Ryan (1987) discuss reasons
for preferring reverse regression over these grouping procedures.
6This approach assumes implicitly that the market is able to forecast accurately the prior years
earnings number well in advance of its actual release. Thus, using the prior years earnings as a
basis for predicting the current years earnings (even though the former has not yet been released)
only assumes that the market makes an unbiased assessment of what the number will actually be.
To the extent this assumption does not hold, it weakens the earnings/returns association when
return cumulation begins in an earlier period. Evidence in Beaver et al. (1980), Collins et al.
(1987), and Freeman (1987) suggests that the market anticipates earnings changes from t - 1 to t
well before earnings for t - 1 are reported.
154 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients

based largely on the evidence in Beaver, Lambert, and Ryan (1987). In section
2 we posited that the ERC is related to four factors: earnings persistence (+),
growth (+), risk (-), and interest rates (-). In reverse regressions, these
functional relations are inverted. That means the RRC increases in risk and
interest rates and decreases in earnings persistence and growth. These predic-
tions are expected to hold when earnings changes are scaled by price which is
the scaling variable according to the analysis in section 2 and in Christie
(1987). However, if earnings changes are scaled by previous years earnings as
in Beaver et al. (1980) and many other earnings association studies, then RRC
is likely to exhibit lesser association with the four determinants for reasons
discussed in section 3.3.3.
The inverse of the estimated RRC is the upper bound for ERC. Therefore,
attempts to infer the earnings process or to place other economic interpreta-
tions on the inverse of the estimated RRC must be approached with caution.
Accordingly, we interpret the RRCs conservatively and use significance tests
only to judge whether its determinants have the predicted signs.

3.3. I. Empirical measures of returns

The analysis in section 2 suggests that the appropriate return metric is


R,, - E,_,( Ri,). We use R,, (return inclusive of dividends) throughout as a
first approximation for three reasons:
(1) E,_ t( R,,) is an ex ante measure of expected return, but ex ante measures
of riskless rates and risk premia are not readily available. Most studies use
an ex post measure of E,_ i( R,,) conditional on the realized market return
for period t which introduces error into the return metric.
(2) Relative to the temporal and cross-sectional variability in R,,, the variabil-
ity in E,_,( Rjt) is small. Hence, the use of R,, - E,_i( Rjt) essentially
amounts to using Ri,.
(3) Beaver et al. (1980) and Beaver, Lambert, and Ryan (1987) report that the
earnings/returns relation is essentially the same whether one uses R,,
inclusive or exclusive of dividends or market model prediction errors.

3.3.2. Proxy for unexpected earnings

While the model in section 2 is in terms of a generic unexpected earnings


measure (UX), our empirical analysis uses annual earnings change (scaled by
price or previous years earnings) as a proxy for UX. There are at lease three
reasons for this choice.
(1) Many annual earnings/returns association studies use a random walk
model as a proxy for the markets earnings expectation as of the beginning
of the year. Thus, annual earnings change is the appropriate proxy for
unexpected earnings.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 155

(2) Unexpected earnings using more sophisticated ARIMA models require a


relatively long data history (20-30 years) to estimate parameter values.
This would restrict our sample severely and reduce the range of size and
risk profiles which are determinants of the ERCs. We do, however, use an
IMA(l, 1) model to estimate earnings persistence for a subset of our
sample firms with the requisite data and these results are reported below.
(3) The two empirical procedures described above (i.e., reverse regression and
expanding the return holding period) reduce the potential measurement
error that results from using annual earnings changes as a proxy for VX,,.

??
_._.3. Scaling factor for earnings changes

Although the specification of ERC in section 2 suggests the appropriate


scale variable for AX is Pt_l, we also report results when AX, is scaled by
X ,_I.7 This is to demonstrate the sensitivity of our findings with respect to a
popular alternative scale variable and to enhance the comparability of our
results with previous studies that have used A X,/X,_ 1 variable to investigate
the earnings/returns relation [e.g., Beaver et al. (1980) Burgstahler (1981)
Beaver, Lambert, and Ryan (1987) and Collins et al. (1987)J.
Another reason for using A X,/X,_, variable is to test the implication
following from the assumption in Ohlson (1983) and Beaver et al. (1980) that
the earnings capitalization rate (p) is a temporal constant. If this assumption
is true, then the slope in the earnings/returns relation is smaller by a factor of
l/p when AX, is scaled by X,_ 1 versus Pt_l, where p is the temporal constant
earnings multiple that incorporates interest rates, risk, growth, and earnings
persistence. That is, ERC when AX, scaled by X,_ 1 = (ERC when A X, scaled
by P,_l)/p. Thus, with constant capitalization rates, scaling by X,_ 1 elimi-
nates (or reduces substantially) both cross-sectional and temporal dispersion
in ERCs. Thus, factors such as risk, persistence, growth, or interest rate should
possess little explanatory power in the earnings/returns relation.
We hasten to note that these predictions are conditional on the descriptive
validity of the assumptions underlying the Beaver et al. (1980) or Ohlson
(1983) models. These results may not obtain empirically for at least three
reasons:

(1) p is likely to vary with changes in risk-free interest rates or risk premia.
Casual observation suggests that P/E ratios are relatively high (low)
during low (high) interest rate periods. Therefore, in a relation between

Because annual earnings change is used as proxy for UX, we use AX instead of UX in the
remainder of the paper.
Some argue that price is not an appropriate deflator and conclude, at least implicitly. that some
other deflator like previous years earnings is a more appropriate deflator [see. e.g., Lustgarten
(1982)].
156 D. W. Collins and S.P. Kothari, Variaiion in earnings response coefficients

nominal returns and earnings changes, ERCs are likely to vary over time
even when scaling by X,_ i.
(2) While price is expressed as a multiple of expected or current earnings, the
prices/earnings relation is unlikely to be deterministic. A more realistic
prices/earnings relation would be

where qit is a random disturbance. Thus, when scaling by Xt_i, it is not


obvious that the effect is simply to render the ERC smaller by a factor of
l/p as shown earlier.
(3)Measurement error in the earnings variable is another factor affecting the
magnitude of the ERCs through time. This is particularly true when
reported earnings for t - 1 are negative. (We, like others, delete such
observations from our empirical analysis.)
In summary, we make clear-cut predictions about the sign of the relation
between ERCs and risk, persistence, growth, and interest rates when AX, is
scaled by Pt_l. However, when scaling by X,_ 1 the only clear prediction is
that the relation between these factors and ERC will be zero if the assumption
of constant temporal capitalization rate on earnings holds. If this assumption
does not hold, then the predicted relations between these factors and ERCs
noted in section 2 will be attenuated or may even change sign.

4. Sample selection and descriptive statistics

4.1. Sample selection

We initially identify a sample of firms from the Compustat Industrial


Annual and the Compustat Research Annual tapes with a December 31 fiscal
year-end and a minimum of three years of earnings data for each year t from
1968 to 1982 (a total of 15 years). The December 31 fiscal year-end criterion
is imposed to facilitate data analysis and enhance comparisons with previous
studies that have imposed this restriction [e.g., Beaver et al. (1980) and
Kormendi and Lipe (1987)]. From the Compustat sample, only firms listed on
the NYSE are included for further analysis. We limit the sample to NYSE
firms because we use monthly return data to estimate systematic risk and also
use monthly returns to obtain buy-and-hold returns over varying holding

Identifying firms from the Compustat Research Annual tape reduces the severity of the
survivorship bias inherent in sampling only from the Compustat Industrial Annual tape. Also,
data for firms delisted because of mergers, acquisitions, and takeovers are available on the
research tape for the years prior to their mergers, etc. We increase the sample size by approxi-
mately 20% by using the research tape.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 157

periods. The CRSP monthly returns tape contains only NYSE-listed firms. We
use monthly return data to estimate systematic risk because beta estimates
using daily returns data are biased and inconsistent [Scholes and Williams
(1977)]. The subset of NYSE firms for which monthly return data are available
on the CRSP tapes for eight consecutive years ending in year t + 1 is included
in the final sample. Monthly returns for the five years up to the end of year
t - 2 are used in estimating the firms systematic risk (market model betas)
and returns over varying lengths of time for the next three years (i.e., years
t - 1 to t + 1) are used in the regression analysis. These criteria yield a sample
of 9776 firm-year observations. The number of observations in each year
varies from 519 in 1968 to 730 in 1978.

4.2. Descriptive statistics


Descriptive statistics for the sample are presented in table 2. Since the
sample selection criteria result in only firms with NYSE listing, the sample
firms are above average in their equity market values relative to all publicly
traded stocks. The mean firm size is $860.4 million. However, a large standard
deviation ($2644.2 million) of the sample distribution of market values and the
minimum and maximum market values of equity of the sample firms suggest
there is considerable variation in firm size within our sample. This is important
because one of our objectives is to assess whether ERCs are a function of firm
size and to demonstrate that this variation is sensitive to the definition of the
return holding period.
Each securitys systematic risk is estimated by regressing monthly returns
over sixty months on the CRSP equally weighted market return index. The
sample mean beta is 0.92 which suggests that the sample is slightly less risky
than the average security listed on the NYSE. This is expected because the
sample selection criteria are biased towards including larger NYSE firms and
previous evidence suggests that firm size and beta are inversely related [see, for
example, Banz (1981)].
Summary statistics for the percentage change in earnings variable (%AX,)
are based on 9045 firm-year observations because we exclude observations
with a negative denominator or observations with I%AX,l > 2008. The
reduction in sample size is due largely to firms reporting losses (negative
denominator) and thus represents an asymmetric loss in the sample. This is a
problem that is common to all the research studies using the %AX, variable.
On average, firms in our sample report an annual increase of 7.85% in their
earnings over the years 1978 to 1982. The second earnings variable, change in
earnings deflated by price (A Xt/P1_r), is free from the negative denominator

The decision to exclude observations with ISA X,( > 200% may seem arbitrary, but it is
consistent with previous research in this area.
158 D. W. Collins and S.P. Kothari, Variation in earnings resporwe coeJ%ents

Table 2
Summary statistics for market value of equity, risk, and change in earnings: Sample of 9776
firm-years from 1968-82.=

Standard
Variable N Mean Median deviation Minimum Maximum

Market 9776 860.4 245.3 2644.1 1.86 47,888


value of
equityb
Risk 9776 0.92 0.87 0.40 - 0.37d 3.01
(beta)
Percentage 9045 7.85% 8.63% 43.22% - 200.0% 198.0%
change in
earnings
Change in 9718 0.82% 0.77% 10.94% - 97.85% 99.76%
earnings
scaled by
price

Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual
Research tape with a December 31 fiscal year-end and a minimum of three years of earnings data
during 1968-82 is included in the sample. From this sample, the subset for which monthly return
data are available for eight consecutive years ending in 1969-83 is included in the sample
analyzed in this study.
bMarket value of equity is defined as the beginning of the year share price times the number of
shares outstanding; in millions of dollars.
Market model beta estimated by regressing monthly returns over five years on the NYSE
equally weighted index.
dMarket model betas of three securities are negative.
Percentage change in earnings, WAX,, is change in earnings per share from year t - 1 to r
divided by the earnings per share for year t - 1, all adjusted for stock splits and dividends. A total
of 731 observations with negative denominators or \%A X,1 z 200% are excluded.
Change in earnings scaled by price, A X,/P,_ Lr is change in earnings per share from year t - 1
to t divided by share price at the beginning of year t. A total of 58 observations with
IAX,/P,_,l> 100% are excluded.

problem. Therefore, it has a larger sample of 9718 firm-year observations.


Observations with (AX,/P,_,I > 100% are excluded which causes a small
reduction in sample size from 9776 to 9718 observations. The sample mean
and standard deviation for the distribution of AX/P,_, are 0.816% and
10.94%.

5. Firm size, information environment, and holding period returns

As noted earlier, a contemporaneous regression of annual returns on earn-


ings changes understates the ERC and the degree of understatement varies

Once again, the decision to exclude observations with /A X,/P,_ ,( > 100% is arbitrary, but, as
can be seen from table 2, these observations are more than nine standard deviations away from
the mean. Inclusion of these observations in the sample would likely have an undue influence on
the estimated regression coefficients.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 159

with firm size. If firm size is correlated with risk, growth, and persistence
(which seems likely), then failing to control for differences in the lead-lag
structure of returns and earnings will confound tests for differences in the
earnings/returns relation due to the factors identified earlier.
To demonstrate the relation between firm size and the lead-lag structure,
we regress earnings changes (scaled by Pt_lor X,_,) on security returns from
the contemporaneous and lagged fiscal year according to the following model:

where, consistent with previous research, R;,is measured from April of year t
to March of year t + 1 and R it- I is measured in an analogous fashion.
Results in the first two rows of table 3, using all stocks in the sample, reveal
that coefficients on both current and lagged years returns are of comparable
magnitude and highly significant. l2 Thus a nontrivial portion of the events
contributing to accounting earnings changks in the current period are captured
in security returns from an earlier period.
To ascertain whether the degree to which lagged returns explain earnings
changes varies with firm size, we partition our sample into three equal-sized
groups by ranking firms each year according to the beginning of year equity
market vales. Results of estimating eq. (8) for the small, medium, and large
firm groups are reported in the lower portion of table 3. Lagged years returns
possess significant explanatory power for all three size groups. However, the
magnitude and significance of f1 in relation to f2 suggest that R,+,is more
important in explaining earnings changes for large versus small firms, which is
consistent with Collins et al. (1987) and Freemen (1987).
While the above analysis suggests that the earnings/returns association is
enhanced by including returns from an earlier time frame, the results do not
identify exactly how far back one should go. This is difficult to specify a priori
and will vary as a function of the timing of valuation relevant economic
events, the nature of a firms information environment, and how quickly
economic events are captured in the accounting earnings numbers. Basically,
then, it becomes an empirical issue.
To shed some light on this issue, we regress earnings changes on returns
where the return measurement is started at varying points in time and
extended over varying time frames. We always use buy-and-hold returns.
Specifically, we vary the start of the return cumulation process from January
of fiscal year t - 1 to June of fiscal year t and allow the length of the holding

*The t-statistic may be overstated because cross-dependencies are ignored. However, even after
downward adjustments the p-value is likely to be less than 0.01.
160 D. W. Collins and S.P. Kothari, Variation in earnings response coejicients

Table 3
Pooled time series cross-sectional regression of earnings changes on contemporaneous and lagged
security returns: 1968-82.a

I ,. ,.
Dependent
variable Firm sizeb NC ( t-s&)d (r-skgd ( t-s:2at)d Adj. R2

AT/p,-, All 9718 0.001 0.038 0.058 3.56%


(3.04) (10.56) (16.82)
%AX, All 9045 0.034 0.256 0.310 6.90
(7.18) (16.78) (21.47)

AX/p,-, Small 3215 0.005 0.031 0.083 3.68


(1.87) (3.86) (10.79)

AX/p,-, Medium 3251 - 0.002 0.045 0.043 4.61


(- 1.09) (9.43) (9.34)

AX/p,-, Large 3252 0.000 0.044 0.033 5.72


(0.33) (11.69) (9.31)
%AX, Small 2725 0.032 0.213 0.384 6.76
(2.92) (6.90) (12.93)
%AX, Medium 3126 0.024 0.255 0.293 7.28
(3.14) (10.54) (12.70)
%AX, Large 3194 0.045 0.311 0.231 7.97
(7.37) (13.94) (10.99)

Sample selection criteria are given in footnote a to table 2.


A X,/P,_, is change in EPS from year t - 1 to t divided by share price at the end of year t - 1.
A total of 58 observations with IA X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or Is&AX,1 z 200% are excluded.
R ,,- L is raw return from April of year t - 1 to March of year t and R,, is raw return from April
of year r to March of year r + 1.
bAll the sample firms are ranked every year on the beginning-of-the-year market values of equity
and assigned to the small, medium, and large firm portfolios in equal numbers.
N is number of firm-year observations in each regressions. N is not equal in each regressions
because of asymmetric reduction in sample due to negative denominators or outliers.
dt-statistic of 1.96 implies a p-value of 0.05 and t-statistic of 2.58 implies a p-value of 0.01
using two-tailed tests.

period to range from 12 to 18 months.13 For example, when returns are


measured over 14 months, the first 16month period is from January of year
t - 1 through February of year t and the 18th 1Cmonth period begins in June
of year t and extends through July of year t + 1.
Since size is hypothesized to affect the lead-lag structure between returns
and earnings changes we estimate regressions separately for small, medium,
and large firm groups. The entire analysis is performed using both earnings

t3We also used periods longer than 18 months, but the earnings/returns association is
maximized using returns measured over periods shorter than 18 months. We, therefore, do not
report these results.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 161

change variables, i.e.., AXJP,_, and %AX,, as the dependent variable. Since
the dependent variable is the same across all models, adjusted R2 is the
criterion used for identifying the starting point and length of cumulation
period that maximizes the earnings/returns association.4 Obviously our re-
sults are sample- and period-specific and only indicate the sensitivity of the
earnings association tests to the length of the holding period return. Hopefully,
these results will guide future research in specifying return holding periods in
association study contexts.
Adjusted R2s from the regressions of SAX, on returns measured over
alternative periods for the large and small firm portfolios are plotted in figs. 1
and 2.15 Fig. 1 reveals that the length and starting month of the return
measurement have a dramatic effect. For example, the typically selected
12-month April to March return period results in an adjusted R2 of 2.41%
which suggests a weak association between large firms price and earnings
changes. However, when the 12-month period begins in January the explana-
tory power jumps to 6.49%. The maximum adjusted R2 of 10.94% is attained
when a 15-month period starting in August of year t - 1 is used. Thus, the
explanatory power for large firms increases substantially by increasing the
length of the holding period from 12 to 15 months and by measuring returns
from August of year t - 1 instead of April of year t. The same return
measurement period maximizes the models explanatory power for medium
size firms and overall the results are quite similar to those in fig. 1.
Turning to fig. 2, for small firms, adjusted R2 is maximized once again using
a 15-month period but beginning in November of year t - 1. This is consistent
with the regression results for large and small firms reported in table 3 and the
evidence in Freeman (1987) and Collins et al. (1987). The maximum adjusted
R2 for small firms is 9.34%.
Comparing figs. 1 and 2 demonstrates clearly the systematic differences
between large and small firms in the extent to which alternative holding
periods dominate the conventional April-March or January-December peri-
ods. There are many fewer holding periods that dominate a January-Decem-
ber holding period for small firms as compared to large firms. The association
between earnings and price changes is maximized for holding periods (of fixed

14Conclusions based on adjusted Rs are not affected by our choice of reverse regression. This
follows because in case of simple regression adjusted R* is unchanged when the independent and
dependent variables are interchanged [see Maddala (1977, pp. 77-79)]. Our discussion of the
sensitivity of the degree of association to length and cumulation period of returns ignores
magnitudes of slope coefficients from all the regressions. The magnitude of the slope coefficient is
maximized when adjusted R* is maximized since R* is an increasing function of the estimated
slope when it is positive.
To improve the visual clarity of the graphs, figs. 1 and 2 do not plot adjusted Rs when
returns are measured over 17 and 18 months. The results for A X,/P,_ I are virtually identical to
those reported here.
D. W. Cohs und S. P. Kothari, Variation in eurrtings response coeficients

15 Month Holding Period


Aug, t-l - Ott, t

Jan, t - Dee, t

0 I I I I I I -J
0 1 6 12 16
at- 1 1
t --__

Beginning month for the return holding period

12 - month return holding period 4 15 - month return holding period

13 - month return holding period -El- 16 - month return holding period

14 - month return holding period

Fig. 1. Large-firm sample results: Association of various holding period returns with earnings
changes in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year f.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 163

15 Month Holding Period


Nov, t-1 - Jan. t+l

I
r Jan, I - Dee,

t - Mar. I+1

0 1 6 12 16
c------- I- 1 t --__

Beginning month for the return holding period

+I- 12 - month return holding period


+ 15 - month return holding period

+ 13 - month return holding period 16 - month return holding period


il-

f 14 _ month return holding period

Fig. 2. Small-firm sample results: Association of various holding period returns with earnings
changes in period t. Month 1 is January of fiscal year t - 1 and month 18 is June of fiscal year t.
164 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

length) that begin at an earlier point in time for large firms compared to small
firms.16
To summarize, a conventional 1Zmonth return period understates the
earnings/returns association, particularly for larger firms. The association is
maximized when returns are measured over 15 months starting from August of
year t - 1 for large and medium firms and November of year t - 1 for small
firms. All further analysis is performed using returns measured over the
15-month intervals appropriate for each size grouping. In the remainder of
the analysis the AX,/P,_, variable is defined as AX, scaled by price at the
beginning of the appropriate 15-month return interval for each firm. This
ensures that the scale variable is consistent with the model in section 2.

6. Determinants of earnings response coefficients: Empirical evidence

6.1. Interest rates and temporal differences in response coeflcients


Based on the model in section 2, the rate at which earnings are capitalized
into prices is inversely related to the risk-free interest rate. From an empirical
standpoint the capitalization rate would be a function of current as well as
expected future interest rates or the term structure of interest rates. We use
yields on long-term U.S. Government bonds reported in Ibbotson and
Sinquefield (1985) as a proxy for the risk-free interest rate and assume that the
term structure is flat. While this may not be descriptively valid, it simplifies
the analysis and biases against finding a temporal relation between interest
rates and the RRCs.18
The correlation between long-term U.S. Government bond yields and the
RRCs from annual regressions of earnings changes on returns measures the

t6A potential limitation of extending the return interval to include lagged periods returns is that
part of the price change in f - 1 is likely to capture shocks or changes in accounting earnings for
that period. If there is positive serial correlation in successive earnings changes this may create a
correlated omitted variables problem and overstate the coefficient on the lagged periods return.
This potential problem can be addressed by including lagged earnings changes as an additional
explanatory variable. Nayar and Rozeff (1988) explore this issue using an earnings/returns
specification and sample virtually identical to ours. They find only modest negative partial
correlations between successive earnings changes and the coefficient on lagged returns remains
positive and highly significant with lagged earnings changes included as an additional explanatory
variable.
We also used one-year T-bill rates with slightly weaker but similar results as reported here.
These results are available from the authors upon request.
Even if we were to identify the term structure of interest rates, it is not obvious how to use
that information in relating the response coefficient to interest rates. It seems that some kind of a
weighted average interest rate is called for where the weights are proportional to the expected
levels of interest rates and inversely proportional to their timing. We do not know the extent of
improvement in the relation between interest rates and RRCs that would result from such an
exercise and leave it for future research.
D. W. Collins and S.P. Kothari, Variation in earnings response coeficients 165

Table 4
Product moment and rank order correlations between long-term Government bond yields and
annual return response coetlicients estimated by re essing annual earnings changes on
security retums.a. Fr

Correlation between interest rates


and return response coeffrcientse
Earnings change Product moment Rank order
variable Return periodd (p-value) (p-value)

A x,/P,-, January-December 0.68 0.84


(0.005) (0.001)
s&Ax, January-December 0.50 0.55
(0.060) (0.035)

AX/P,-, 15 months 0.73 0.85


(0.002) (0.001)
%AX, 15 months 0.55 0.50
(0.034) (0.056)

Long-term Government bond yields used as proxies for risk-free interest rates are taken from
Ibbotson and Sinquefield (1985).
bAnnual return response coefficients (n,s) are estimated from the following annual reverse
regressions: %A X,, or A X,,/P,,_ 1= %, + yl, R,, + E,,. The sample selection criteria employed to
obtain data for these regressions are given in footnote a to table 2.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
relevant return period (i.e., 12- or 15-month period). A total of 58 observations with /A X,/P,_ 1I>
100% are excluded.
%AX, is change in EPS from year t - 1 to t divided by the EPS for year f - 1. A total of 731
observations with negative denominators or IBA X,1 > 200% are excluded.
Return period refers to the independent variable in the annual regressions. R,, is raw return on
security i over the relevant return period.
dReturn period January-December is 12 months starting from January of fiscal year t for each
security. The 15-month return period starts in November of fiscal year t - 1 for the small firms
and starts in August of fiscal year t - 1 for the medium and large firms,
All correlations are based on 15 annual observations for the period 1968 to 1982.

sensitivity of the earnings/returns relation to interest rate fluctuations. Since


we estimate reverse regressions, correlations are expected to be positive. Also,
as noted earlier the correlation is expected to be weaker when the dependent
variable is SAX,.
Product moment and rank order correlations between the RRCs and inter-
est rates (i.e., bond yields) are summarized in table 4. Because interest rates are
as of the beginning of the year, RRCs are estimated using returns measured
over 12 months beginning in January. However, to be consistent with the
evidence that covariation between earnings and price changes is maximized
using returns measured over 15month periods, we also report correlations
based on RRCs estimated using 15-month returns. Using 15month returns
and A X,/P,_ 1, product moment (rank order) correlation between the response
coefficient and interest rates is 0.73 (0.85) which has a p-value of 0.002 (0.001).
This evidence is consistent with the hypothesized relation between interest
166 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

rates and RRCs. The p-values are small despite only 15 annual observations
(1968-82) used to estimate correlations. Correlations using response coeffi-
cients based on 1Zmonth returns are comparable to those based on 15-month
returns.
As expected, the correlations when %AX, is the dependent variable in the
earnings/returns relation are smaller compared to those using A X,/P,_,.
Using 15-month returns and SAX,, product moment (rank order) correlation
between the response coefficient and interest rates is 0.55 (0.50) which has a
p-value of 0.034 (0.056). These results are consistent with interest rate fluctua-
tions having less influence on response coefficients estimated with the previous
years earnings as the scale factor on AX,. However, the correlations are still
consistently positive and statistically significant. Thus, the sensitivity to inter-
est rates is reduced but not eliminated by using earnings as the scale factor. A
likely reason for the association is that the response coefficient for year t also
reflects the effect of any interest rate change during the year on the returns on
all securities.

6.2. Risk and growth expectations as determinants of the return


response coeficient

This section analyzes the factors explaining cross-sectional differences in the


earnings/returns relation. First, we test the effects of risk and growth (and/or
persistence) using the entire sample of firms identified earlier. To estimate
firm-specific persistence using time series analysis requires a lengthy earnings
history. Since this requirement reduces our sample by about one-half, we
report the effects of persistence on the earnings/returns relation in the
following section using only the subsample that meets the necessary data
requirements.
We use common stock betas estimated from monthly returns as a proxy for
the riskiness of earnings. The market value to book value of equity relative to
the median market value to book value ratio of all the sample firms in each
year is used as a proxy for the firms economic growth opportunities. The
difference between the market value and book value of equity when measured
relative to the market average roughly represents the value of investment
opportunities facing the firm [Smith and Watts (1986)]. The market to book
value ratio depends upon the extent to which the firms return on its existing
assets and expected future investments exceeds its required rate of return on
equity. Since future earnings are affected by the growth opportunities, the
higher the market to book value of equity ratio, the higher the expected
earnings growth. We use the market to book value of equity ratio as of the
beginning of each year t as a proxy for expected growth. This proxy for
growth, however, is also likely to be affected by earnings persistence. That is,
high market to book value of equity ratio is likely to be associated with high
D. W. Collins and S. P. Kothan. Variation m earnings response coeficients 167

persistence as well. Therefore, on the basis of our regression results we cannot


conclude unambiguously that ERC is affected by growth. Rather, a relation
between market to book ratio of equity and ERC will suggest that growth
and/or persistence affect ERC.
To assess the effect of risk and growth on the RRC, the following model is
estimated in year t from 1968 to 1982:

A X,,/P,,- 1 or %AX,, = yo,+ Ed,, + Y~$W * R,, + Y&~ * R,,+ c.

(9)
where

R,, = return measured over the appropriate U-month period for the small,
medium, and large firms,
MB,, = market to book value of equity ratio, calculated at the beginning of
year t,19
84, = market model systematic risk.20
The coefficient on R,,, yl, is expected to be positive. When AX, is scaled by
P r_l, y2 is hypothesized to be negative because, in the reverse regression, the
RRC is decreasing in growth. The effect of risk on the RRC is expected to be
positive. When scaling by X,_, we make no predictions on the signs of the
latter two coefficients for the reasons noted in section 3.3.3.
The results of estimating eq. (9) are reported in table 5. The top number
across from each independent variable is the sample mean of the parameter
estimates from the 15 yearly cross-sectional regresssions, and the t-statistic is
calculated from the standard error of the sampling distribution of parameter
estimates. Since statistical inferences are based on standard errors from the

When book value of equity was negative (4 firm-year observations). MB,, was set equal to
zero. This is done because negative MB,, values do not have an economic interpretation in the
context of the regression model being estimated. To avoid undue influence of very large values of
MB,, on the regression coefficient estimates, MB,, > 5 values are set equal to 5 (less than 5%
firm-year observations). All the results are insensitive to truncating extreme values at MB,, = 3, 4,
or 6.
*We also estimated eq. (9) and all other models in the remainder of the paper by nominally
classifying firms into high and low growth or risk portfolios. That is, we did not use the market to
book ratios or beta as a continuous variable. In the regressions, the independent variables were
dummies for risk or growth times R,,. The dummies were assinged a value of 1 for high growth
firms or high risk firms, and 0 for low growth or low risk firms. The high/low classification was
redetermined in each year. Similarly, when interest rate and persistence were included among the
independent variables, high interest rate years or high persistence firms were assigned a value of 1
and 0 otherwise. The primary motivation for using dummy variables instead of continuous
variables was that these variables are likely to be measured with error. All the results using
dummy variable times returns instead of the continuous variable times returns are virtually
indistinguishable from those reported in this paper. All these results are available to interested
readers.
168 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients

Table 5
Effect of risk and growth expectations on the response coefficient from an earnings/price relation:
Annual regression analysis from 1968-82.a
AX,,/P,,-, or %A&, = YO, + x,R,, + YW+% * 4, + n,B,, * R,, + E,,

Expected sign when Time series mean (t-statistic)


dependent variable is of estimated coefficientsb
Independent variable AX/p,-, BAX, AX/p,-, %AE,

Intercept - 0.001 0.023


(0.21) (0.62)
Return (R,,) + + 0.080** 0.661**
(4.92) (11.09)
Growth (MB,, * R,,) - ? -0.021** -0.57**
( - 4.31) ( - 4.69)
Risk (R,, * R,,) + ? 0.028* - 0.067
(2.67) (- 1.70)

Sample selection criteria are given in footnote a to table 2.


AX,/P,_, is change in EPS from year t - 1 to t divided by share price at the beginning of the
U-month return period. A total of 58 observations with [A X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or [%A X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15-month period beginning in November of year r - 1 for the small firms and over a 15-month
period beginning in August of year t - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
/3,, is the market mode1 systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
bSignificance at OL= 5% is indicated by one asterisk (*) and at Q = 1% by two asterisks (**). One
tailed t-tests are performed when sign of the coefficient is predicted. Otherwise, two-tailed tests are
performed.

time series sampling distribution of the regression coefficients, they are free
from the cross-sectional dependence problem described in Bernard (1987).
Results using the A X,/P,_, variable are uniformly consistent with our
hypotheses. The ur coefficient on return is positive and significant. v2 on the
growth/return interaction is equal to -0.021 and reliably negative as pre-
dicted. Similarly, the response coefficient increases in risk as seen from the
coefficient estimate of 0.028 which is significant at 1% level. The evidence
suggests risk and growth (and/or persistence) significantly impact the RRC
when earnings change is scaled by price.
The coefficient estimates on the return and growth variables from the
regression using %AX, as the dependent variable have the same sign as when
AX, is scaled by P,_l. The coefficient for which a prediction can be made, j$
is positive and highly significant. The coefficient on the growth/return interac-
tion (j$) too is significant and negative. Thus, when X,_, is the scale variable,
the RRC is significantly influenced by growth (and/or persistence). The
risk/return interaction (7s) is not significantly different from zero. This result
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 169

is consistent with the effect of risk on cross-sectional dispersion in the


earnings/returns relation being attenuated when scaling by X,-r.
To provide additional evidence on variation in the return response coeffi-
cient, we estimate the following pooled cross-sectional regression:

+YA * R;,+ rJ, * R,,+ &,t,

where Db8 to D,, are dummy variables taking on a value of 1 for data from
year t and 0 otherwise and I, is the long-term risk-free interest rate in year t.
All other variables are as defined earlier. We do not include R,, as an
independent variable because, when annual dummies are included, Ri, and
I * Ri, are almost perfectly correlated. Note that I is a cross-sectional con-
stant in any given year which means I * R,, is a scalar multiple of Ri, in any
given year. Use of annual dummy variables reduces cross-correlation because
the dummies control the effects of economy-wide changes in earnings in each
year.21
Results in table 6 reveal that for the AX,/P,_, variable, all the estimated
coefficients have their predicted signs and are statistically significant. The
coefficient on the interest/return interaction term is highly significant regard-
less of the scale variable. This indicates that the capitalization rate on earnings
and the sensitivity of price changes to earnings changes is not an intertemporal
constant as was assumed in Beaver et al. (1980) and Ohlson (1983).22 When
AX, is scaled by X,_, all coefficients have the same sign as when scaling by
PI_ 1. The coefficients on growth (and/or persistence) and interest rate interac-
tion variables are significant, but the risk coefficient is insignificantly different
from zero. The adjusted R2 is 12.73% using the AX/P,_, variable and 17.98%
using the %AX, variable. By comparison, when we estimate the regression with
an intercept and R, as the only explanatory variable where R, is measured
over the conventional window of April, to March,+, for all firms, the adjusted
R2 is 2.47% using AX/P,_, and 4.01% when using %AX,. Clearly, there is a
substantial improvement in the explanatory power of the model that incorpo-
rates year dummies and risk, growth (and/or persistence), and interest rate
terms to account for variation in the response coefficients.

*tGeneralized least squares would control for the remaining cross-correlation and heteroskedas-
ticity problems, but with only 15 annual observations the variance-covariance matrix cannot be
estimated for a sample of several hundred firms in each year.
**Because of the high collinearity between the return and the interest/return interaction
variables we cannot unambiguously attribute the significance of the interest rate variable to the
RRCs sensitivity to interest rate variation through time. However, results in table 6 and table 4
put together provide compelling evidence that the RRC is related positively to interest rates
through time.
170 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients

Table 6
Effect of risk, growth expectations, and interest rates on the response coefficient from an
earnings/returns relation: Pooled regression analysis using data from 1968-82.*
AX,,/p,,~,or%AX,,=y,+u,,D,,+ . +Y~~D~~+Y~MB,,*R,,+Y~P,,*R,~+Y~~*R,~+~~

Expected sign when Estimated coetlicient ( r-statistic)b


dependent variable is Dependent variable
Independent variable %AX,

Intercept - 0.059** -0.272**


(- 15.58) (- 16.62)
D6X 0.054** 0.273**
(9.50) (11.30)
D69 0.062** 0.276**
(11.03) (11.52)
D 70 0.060** 0.250**
(10.82) (10.49)

D71
0.062** 0.280**
(11.27) (11.77)
D 72 0.076** 0.451**
(14.00) (19.43)
D 73 0.083** 0.504**
(15.28) (21.90)
D 74 0.090** 0.467*
(16.31) (19.88)

45
0.030** 0.180**
(5.75) (7.97)
D 76 0.066** 0.331**
(12.61) (14.86)
D 77 0.067** 0.356**
(12.89) (16.11)
D 7R 0.080** 0.413**
(15.40) (18.54)
D 79 0.069** 0.338**
(13.26) (15.38)
D 80 0.027** 0.119**
(5.10) (5.39)

43,
0.050** 0.230**
(9.56) (10.35)
Growth (MB,, * R,,) _ ? - 0.024** - 0.042**
(- 11.70) (-4.75)
Risk (P,, * K,,) + ? 0.018** PO.013
(3.36) ( - 0.53)
Interest (I, * R,,) + ? 0.012** 0.062**
(15.36) (17.78)
Adjusted R* 12.73% 17.98%
N 9718 9045

For table footnotes see next page.


D. W. Collins and S.P. Kothari, Variation in earnings response coefficients 171

Table 6 (continued)

Sample selection criteria are given in footnote a to table 2.


A X,/P,_, is change in EPS from year t - 1 to f divided by share price at the beginning of the
15-month return period. A total of 58 observations with /A X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year I - 1. A total of 731
observations with negative denominators or ISA X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15.month period beginning in November of year r - 1 for the small firms and over a 15-month
period beginning in August of year [ - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year 1.
/I$, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
I, is the long-term Government bond yield in year t.
DhX through D,, are annual intercept dummies which are set = 1 for observations from
respective years 68 through 81 and area set = 0 otherwise.
hSignificance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One
tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed t-tests
are performed.

To summarize, variation in the earnings/returns relation is explained by


differences in risk, growth (and/or persistence), and interest rate factors when
earnings changes are scaled by Pt_l. The relation between earnings changes
and returns appears to be less sensitive to risk differences when the scale factor
is last years earnings.
Analysis in section 5 revealed that differences in the earnings/returns
relation are related to firm size which is hypothesized to reflect differences in
information environment. We show below that for both definitions of the
earnings change variable firm size is nor incrementally useful in explaining
variation in the RRC once we adjust the holding period return to account for
differences in the information environment and growth and risk factors are
included in the model.
In table 7 we report results of estimating the following model in each year t
from 1968 to 1982:

AX,,/f,-1 or %A-%,
= ~0 + YS,, + ~ztMB,t * R,, + Y3rPir
* R,,

+ y,,Size,, * R,, + qf,

where Size;, = 1 for the medium and large firms and 0 for the small firms
where firms are reclassified every year. all other variables are as defined earlier.
For both specifications of the earnings change variable, v4 is not significantly
different from zero. The size coefficient is - 0.008 (t-statistic = - 0.78) when
P1_ 1 is the scale variable and it is 0.022 (t-statistic = 0.44) when X,_, is the
deflator. Once again, when AX, is scaled by Pt_l all of the other coefficients
172 D. W. Collins and S.P. Kothari, Variarion in earnings response coefficients

Table 1
Effect of risk, growth expectations, and firm size on the response coefficients from an earnings/
returns relation: Annual regression analysis from 1968-82.a
AX,,/P,,~,~~%AX,,=~O,+Y,,R,,+~~,MB,,*R,,+Y,,B,,*R,,+~,,S~~~,,*R,,+F,,

Expected sign when Estimated coefficient (r-statistic)


dependent variable is
Dependent variable
Independent variable AX/p,-, %AX, A X,/P,- L %AX,

Intercept - 0.001 0.023


( - 0.17) (0.64)
Return (R,,) + + 0.089* 0.651**
(4.69) (10.98)
Growth (MB,, * R,,) _ ? - 0.021** ~ 0.060* *
(-4.59) (- 5.10)
Risk (I$, * R,,) + ? 0.025* - 0.059
(2.26) (-1.54)
Size (Size,, * R,,) ? ? - 0.008 0.022
( - 0.78) (0.44)

Sample selection criteria are given in footnote a to table 2.


A X,/P,_, is change in EPS from year 1 - 1 to I divided by share price at the beginning of the
15-month return period. A total of 58 observations with \AX,/P,_,I > 100% are excluded.
%A X, is change in EPS from year t - 1 to 1 divided by the EPS for year t - 1. A total of 731
observations with negative denominators or I%AX,( z 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15-month period beginning in November of year t - 1 for the small firms and over a 15-month
period beginning in August of year I - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
p,, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year I - 2 on the CRSP equally weighted return index.
Size,, = 1 for the medium and large firms and 0 for the small firms.
Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**). One
tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed r-tests
are performed.

have the predicted sign and are statistically significant. Scaling by X,_,
attenuates the influence of risk on the RRC. Growth (and/or persistence)
continues to be significantly associated with the RRC when X,_, is the scale
variable. Overall, the results are consistent with there being no theoretical
justification for incremental explanatory power of the firm size variable on
including risk and growth (and/or persistence) variables to explain cross-sec-
tional variation in the relation between earnings and returns.

6.3. Persistence and response coeficients

In demonstrating a relation between persistence and ERC, the error in


estimating earnings persistence and the error in the proxy for unexpected
D. W. Collins and S.P. Kothari, Variation in eumings response coefficients 173

earnings variable (VX) pose a nontrivial problem. The problem arises because
the error in estimating earnings persistence using an ARIMA model at the
individual firm level can be large. Moreover, this error is likely to be related to
the error in the proxy for UX. If ERC is estimated using eq. (1) it varies
inversely with the measurement error in the lJXi, proxy and a spurious
correlation between estimated persistence and estimated ERC could result
simply because estimation errors in the two variables are correlated.
We analyze the relation between persistence and response coefficients dif-
ferently from previous research and in a way that reduces the correlated
measurement error problem noted above. We first estimate IMA(l, 1) persis-
tence factors of those firms with a complete earnings history on the Compustat
tape. This data restriction cuts our original sample approximately in half. We
then test the interaction of the estimated persistence variable with returns
(8, * R,,) along with other interaction terms in the cross-sectional regression
equation described earlier in eq. (10) and table 6.23 Since we estimate RRCs
rather than ERCs, the coefficient on persistence is predicted to be negative.
Moreover, the dependent variable is the scaled annual earnings change rather
than the ERCs. Since the dependent variable in our analysis is not conditional
on the individually estimated IMA(1,l) models, potential spurious correlation
because of measurement error is reduced.
The limitation of estimating persistence using reported earnings, as noted
earlier, is that the estimate is confounded by earnings growth. Thus, the
persistence estimates also reflect economic growth and this adversely affects
our ability to separately document the growth and persistence effects.24 Be-
cause both persistence and growth proxies are included in the regressions,
coefficients on each reflect each variables incremental effect on the RRC. If
both proxies are measuring the same underlying construct, then incremental
association of each variable with the RRC implies that neither proxy fully
captures the underlying construct. Unfortunately, this cannot be verified
empirically.
The results of adding the earnings persistence variable to the model for the
reduced subsample of firms are reported in table 8. When the dependent
variable is A X,/P,_ 1 the coefficient on persistence is significantly negative as
predicted (-0.051 with a t-statistic of -4.91). For this specification, all the
other factors that are hypothesized to affect the earnings/returns relation (i.e.,
growth, risk, and interest rates) have the predicted sign and are statistically

23Because estimated @s could be positive or negative, we use (1 - 0) instead of -0 as the


multiplier in the persistence/return interaction variable. This ensures that the multiplier is always
positive and the higher the (1 - 0) value the higher the persistence. (1 - 0) is the persistence factor
for an IMA(1, 1) process as seen, for example, in Beaver et al. (1980) or table 1.
24Altematively, as we have noted earlier, the results in the earlier tables could be reflecting the
effect of persistence and growth on the RRC rather than the effect of growth alone.
Table 8
Effect of risk. growth, persistence, and interest rates on the response coefficient from an
earnings/returns relation: Pooled regression analysis using data from 1968-82.a
A X,,/P,, 1or %JX,, = y. + Y~RL~,~ + + yxl4 + x MB,, * R,, + YzP,,* R,,
+ ~3 4 * R,, + x,4 * R,, t r

Expected sign when Estimated coefficient (t-statistic)


dependent variable is
Dependent variable
Independent variable AT/p,-, %AX, AT/p,-, %AX,

Intercept - 0.065** - 0.327**


(- 13.17) (- 15.86)
D68 0.062** 0.333**
(8.98) (11.73)
D69 0.074** 0.372**
(10.71) (13.17)
D 70 0.064** 0.286**
(9.26) (10.09)

D71
0.059** 0.263*
(8.56) (9.17)
D 72 0.077: 0.491**
(11.21) (17.21)

D,, 0.093** 0.579**


(13.49) (20.43)
D 74 0.116** 0.630**
(16.28) (21.48)

D75 0.012 0.132**


(1.75) (4.70)
D 76 0.073** 0.371**
(10.67) (13.06)
D 77 0.072** 0.396*
(10.58) (14.05)
D 7* 0.086** 0.459**
(12.51) (16.23)
D 79 0.079** 0.441**
(11.61) (15.64)
D80 0.030** 0.153**
(4.34) (5.49)

DUl
0.062** 0.333**
(9.10) (11.86)
Growth (MB,, * R,,) ? - 0.024** - 0.066**
(-8.23) (- 5.46)
Risk (P,, * R,,) + ? 0.049** 0.17u**
(5.85) (4.85)
Interest (I, * R,,) ? 0.01s** 0.059**
(12.95) (10.19)
Persistence (0, * R,,) ? - 0.051** 0.062
( - 4.91) (1.36)
Adjusted R2 19.43% 27.33%
N 4841 4587

For table footnotes see next page


D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 175

Table 8 (continued)

Initially any firm listed on the Compustat Industrial Annual or the Compustat Annual
Research tape with a December 31 fiscal year-end and complete earnings data during 1968-82 is
included in the sample. From this sample, the subset for which monthly return data are available
for eight consecutive years ending in 196943 is included in the sample analyzed in this study.
A X,/P,_ 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations with Id X,/P,_, 1z 100% are excluded.
%A X, is change in EPS from year r - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or l%AX,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15-month period beginning in November of year I - 1 for the small firms and over a 15-month
period beginning in August of year t - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year t.
/I,, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
I, is the long-term Government bond yield in year r.
Dbx through OR1 are annual intercept dummies which are set = 1 for observations from
respective years 68 through 81 and are set = 0 otherwise.
8, is the persistence coefficient measured as (1 - 0) from an IMA(l.l) process.
Significance at a = 5% is indicated by one asterisk (*) and at a = 1% by two asterisks (**).
One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed
r-tests are performed.

significant. When the dependent variable is %AX, the coefficient on persis-


tence has a positive sign, but is statistically insignificant. Again, this can be
explained, in part, by the scaling factor, X,-r, which itself is a function of the
same parameters that determine the persistence measures. Finally, the ex-
planatory power of the model applied to the reduced sample is considerably
higher than for the full sample with an adjusted R2 of 19.43%, when AX,/P,_,
is the dependent variable and 27.33% for %AX,. The corresponding adjusted
R2s for the full sample from table 6 are 12.73% and 17.98%.
The significance levels of the various estimated coefficients reported in table
8 could be overstated because the OLS standard errors ignore cross-correlation
among data. We, therefore, estimate a model similar to eq. (9) in each year
from 1968 to 1982. The only difference is that we now include a
persistence/return interaction variable as well. These results are reported in
table 9. Statistical inferences are drawn from the sample mean and standard
error of the coefficient estimates from the 15 yearly cross-sectional regressions.
Results using the A X,/P,_ 1 variable are uniformly consistent with the hypoth-
esized relation between the RRC and risk, growth, and/or persistence factors.
The coefficient on the persistence variable is -0.069 (t-statistic = -2.95)
which is negative at a 5% significance level. When %AX, is the dependent
variable, the coefficients on risk and persistence are not reliably different from
zero, but the coefficient on growth is negatively related to the RRC at 5%
significance level. Overall, the results indicate that risk, growth, and/or
persistence are significant determinants of the RRCs when earnings changes
176 D. W. Collins and S.P. Kothari, Variation in earnings response coefficients

Table 9
Effect of risk, growth expectations and persistence on the response coefficients from an
earnings/returns relation: Annual regression analysis from 1968-82.a
* X,/P,,- I or Ax,, = for + YIN
R,, + Y,,MB,,* 8, + nd,, * R,, + ~a,@,
* 4, + E,I

Expected sign when Estimated coefficient (~tatistic)~


dependent variable is
Dependent variable
Independent variable * x,/P, - , %AX, *X,/p,-, %AX,

Intercept - 0.003 0.23


(-0.36) (0.47)
Return (R,,) + + 0.153** 0.695**
(4.55) (4.08)
Growth _ ? - 0.017** - 0.053*
(/JB,, * R,,)
(-4.14) (-2.31)
Risk (P,, * R,,) + ? 0.051* 0.081
(2.01) (0.84)
Persistence (6, * R,,) _ ? -0.069** - 0.039
( - 2.95) (-0.38)
_____
Sample selection criteria are given in footnote a to table 8.
A X,/P,- 1 is change in EPS from year t - 1 to t divided by share price at the beginning of the
15-month return period. A total of 58 observations with )A X,/P,_ II > 100% are excluded.
%A X, is change in EPS from year t - 1 to t divided by the EPS for year t - 1. A total of 731
observations with negative denominators or l%A X,1 > 200% are excluded.
R,, is raw return on security i over the relevant return window. R,, is measured over a
15-month period beginning in November of year t - 1 for the small firms and over a 15-month
period beginning in August of year I - 1 for the medium and large firms.
MB,, is the market to book value of equity ratio calculated at the beginning of each year 1.
@,, is the market model systematic risk estimate obtained by regressing 60 monthly returns
ending in year t - 2 on the CRSP equally weighted return index.
0, is the persistence coefficient measured as (1 - 8) from an IMA(1, 1) process.
bSigniticance at a = 5% is indicated by one asterisk (*) and at o = 1% by two asterisks (**),
One-tailed r-tests are performed when sign of the coefficient is predicted. Otherwise two-tailed
r-tests are performed.

are scaled by price. However, these factors have less influence on RRCs when
earnings changes are scaled by last years earnings.
Table 10 summarizes how the explanatory power of the earnings/returns
relation is enhanced by varying the return interval and by incorporating terms
that capture the effects of risk, growth, and/or persistence and interest rates
on the RRC. The first two columns report adjusted R*s from models esti-
mated with the full sample, while the last two columns present similar results
for the subsample with complete data throughout our sample period. Compar-
ing the first two rows of table 10 we see that the explanatory power of a model
where earnings changes are regressed on returns more than doubles when we
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 111

Table 10
Effect of varying the return interval and additional independent variables on the explanatory
power of the regression of earnings changes on returns: Regressions using data from 1968-82.

Adjusted R2 from earnings returns regression using


Firms with data for
Full sample all 15 years
Return interval and
independent Dependent variable Dependent variable
Row variables A x,/P,-, %Ax, AX/L, %AX,
_
(1) 12-month April to
March returns 2.47% 4.01% 2.11% 2.96%

(2) 15-month retumsd 6.32 9.87 8.37 13.04

(3a) 15-month returns with


proxies for risk,
growth, and
interest rates 8.14 10.09 11.29 13.22

(3b) 15-month returns with


proxies for risk,
growth, persistence,
and interest rates - 11.63 13.71

(4a) 15-month returns with


annual dummies and
proxies for risk,
growth, and
interest rates 12.73 17.98 19.05 27.31

(4b) 15-month returns with


annual dummies and
proxies for risk,
growth, persistence,
and interest rates 19.43 27.33

Sample selection criteria for the full sample are given in footnote a to table 2 and for the
sa?ple consisting of firms with complete data for 15 years are given in footnote a to table 8.
When full sample is used, there is no proxy for persistence included as an independent
variable.
Table values are adjusted Rs from regressing either A X,/P,_ 1 or % X, on the set of variables
indicated in the left-hand column,
dThe 15-month returns that are associated with the earnings change in period I are measured
from August,_ 1 to November, for large and medium firms and November,_, to February,+ 1 for
small firms.

use a 15month return holding period beginning in August of t - 1 for


large/medium size firms and November of r - 1 for small firms. Adding terms
that proxy for varying levels of risk, growth and/or persistence, and interest
rates (row 3 versus row 2) increases the explanatory power by an additional
10-30S%. Finally, adding annual dummies to capture the year-to-year differ-
ences in average earnings changes contributes an additional 50-708 to the
adjusted R2 of the pooled model (row 4 versus row 3).
178 D. W. Collins and S.P. Kothari, Variation in earnings response coeJicients

Comparing the first and last row of table 10 shows the dramatic improve-
ment achieved by varying the return interval and allowing nonconstant inter-
cept and slope terms in the earnings/returns relation. For the full sample the
adjusted R2 increases by 415% when the dependent variable is A X,/P,_, and
by 348% when the dependent variable is %AX,. The comparable improvements
for the reduced sample of firms with complete earnings data throughout the 15
years of our study were 821% and 823%. Despite these dramatic improvements
in overall explanatory power it is obvious that a substantial amount of
variation (roughly, 70-80s) in accounting earnings changes is unrelated to
security returns. This suggests there is ample room for further refinement in
the earnings/returns relation and/or that accounting earnings contain a large
noise component that is irrelevant to valuing the firm.

7. Summary and implications for future research

This paper extends the empirical literature on the differences in the relation
between earnings and security returns. Using a simple discounted dividends
valuation model we hypothesize that the earnings response coefficient varies
negatively with the risk-free interest rate and systematic risk; and it varies
positively with growth prospects and earnings persistence. This analysis pre-
dicts cross-sectional and temporal variation in the amount of price change
associated with earnings changes.
Our empirical analyses suggest methodological refinements that have impli-
cations for past and future association study research. We examine the
implications of differences in the information environment which are charac-
teristic of the security market. Specifically, we show that conventional associa-
tion study methods that measure returns over the fiscal 1Zmonth period, or
from April, to March,_ r, seriously understate the degree of association be-
tween price changes and earnings changes in an annual association study
context. The price/earnings association improves dramatically on starting the
measurement period earlier than the contemporaneous fiscal period. Varying
the return measurement period for different size firms controls for the infor-
mation environment differences among the large and small firms and also
explains the previous finding that the degree of price change to earnings
change varies with firm size.
Empirical evidence is consistent with the predictions that the ERC increases
in growth and/or persistence and decreases in interest rates and risk. Because
the proxies used for growth and persistence could potentially reflect the effect
of both variables, we cannot conclude unambiguously that growth and persis-
tence affect ERC individually. To reduce the errors-in-variables problem, we
use reverse regression to document the effect of differences in persistence
and/or growth, risk, and interest rates on the response coefficient.
D. W. Collins and S. P. Kothari, Variation in earnings response coefficients 179

7.1. Implications for future research


Evidence in this paper has several implications for interpreting the findings
in previous research and for future research. First, in both association study
and events study contexts, ignoring the sources of cross-sectional and temporal
variation in ERC can result in statistically less precise parameter estimates and
downward biased test statistics on the response coefficients [see Maddala
(1977, ch. 17)]. In addition, the explanatory power of the model would be
reduced.
Second, in certain contexts researchers include various nonearnings mea-
sures to proxy for such constructs as the amount of predisclosure information,
political costs, or contracting costs. Popular variables include firm size and
debt to equity ratios. As noted by Christie (1987) and Easton and Zmijewski
(1989) these other explanatory variables may have significant coefficients
simply because they are correlated with the cross-sectional variation in ERC.
A priori, there is strong reason to suspect this is true for size and debt to
equity ratios. 25 The finding that the earnings/returns relation varies over time
as a function of the risk-free interest rate suggests that temporal pooling of
observations must be approached with caution unless interest rates are in-
cluded in the model.
Finally, to the extent the number and quality of competing information
sources differ cross-sectionally, a researchers ability to document and inter-
pret differences in ERCs is clouded when the information environment differ-
ences are left uncontrolled. Return measurement over periods beginning
earlier than the fiscal year is proposed as one approach to control for the
information environment differences.

7.2. Future extensions

Our analysis suggests a number of extensions. First, the evidence that


differences in the earnings/returns relation are related to interest rate differ-
ences over time suggests the present analysis can be extended to include
variables that predict such changes. Possible explanatory variables include
inflation, money supply, federal budget deficits, and trade deficits. In addition,
financial policy and investment opportunity set variables could be examined in
greater detail as possible determinants of both cross-sectional and temporal
differences in the ERCs.

25Easton and ZmiJewski (1989) find a positive relation between firm size and earnings persis-
tence. Moreover, both theoretically and empirically, debt/equity ratios and betas are positively
associated. This implies a negative relation between leverage and ERC. Therefore, research designs
that restrict the ERC to be constant and include either size or leverage in the regression equation
are likely to find significant coefficients on these variables because they proxy for sources of
cross-sectional variation in the ERCs.
180 D. W. Collins and S. P. Kothari, Variation in earnings response coefficients

Another extension of our analysis of ERCs and interest rates would be to


analyze differences in the market risk premia through time and their impact on
the earnings/returns relation. Possible proxies for ex ante risk premia are
suggested in Merton (1980) Keim and Stambaugh (1986), and French,
Schwert, and Stambaugh (1987) among others. Hopefully, extensions along
these lines will enhance specification of the earnings/returns relation and yield
more powerful tests of the information content of accounting numbers.

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